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September 3, 2013

Why I Fear More Irrational Behavior by Investors

This past May Fed Chairman Ben Bernanke suggested that scaling back the Fed’s $85 billion per month asset purchase program in the near term was a distinct possibility. He also included a qualifier: that such action would only occur with a corresponding improvement in the economy and the jobs market.

However, his qualifier seems to have been largely ignored. As a result of his typically measured comments, and somewhat true to form, the financial markets reacted in melodramatic fashion. Specifically, the yield on the 10-year U.S. Treasury and mortgage rates spiked in a very short period of time. In fact, both increased around 100 basis points.

In the wake of this, we find a number of important observations to ponder concerning the near-term outlook and the potential for further irrational behavior in the financial markets. It appears that risk has been elevated which could leave unsuspecting investors rushing for the exits at some point. Moreover, it happened at a time when the economy is still limping along like an old three-legged dog. What are some of the potential consequences of higher interest rates? Let's dig a little deeper into this important and highly relevant topic.

The Historical Significance of Rising Rates

If history is any indicator, when interest rates rise, it's often a sign of an improving economy. This is partly due to the fact that as economic activity strengthens, along with demand, the cost of capital tends to rise. However, today we understand this is not the case, as economic growth remains weak.

In business, growth initiatives are heavily influenced by the cost of capital. As interest rates rise, companies are forced to pay a higher price to finance activities such as R&D and planned expansions. Hence, the problem today is not that the cost of capital is at an extreme level. Rather, it remains near historic lows. The problem lies in the speed with which it rose. What was demonstrated was how quickly rates can spike and how volatile the debt markets can be. That points to a more nervous investor and increases the degree of uncertainty businesses feel over the neo-regulatory policies of the past several years. But that is a story for another time.

Rising Rates and the Intrinsic Value of a Stock

To determine the present value of a stock one must discount its future income stream (i.e., dividends). Hence, as rates rise, the discount rate used in this calculation also rises, placing downward pressure on stock prices. As we've witnessed recently, volatility has increased and stocks have declined over the past several weeks.

Most understand that higher mortgage rates are a headwind for the housing market. However, quantifying this is another matter entirely. Let's consider an example. The median home price in America today is $152,000 (according to Zillow.com) and has been rising. For perspective sake, the median home price was slightly over $300,000 in 2008. Using today's figure and assuming a 20% down payment, a 30-year loan with a 4.0% fixed rate would create a payment (P&I) of $579 per month, or $6,943 annually. If mortgage rates rose by 1.0%%, the new P&I would be $650 per month, or $7,801 per year.

Using the Department of Labor's most recent median income amount of $776 per week, the monthly P&I payment with the 4.0% rate would represent 17.9% of gross income. However, if mortgage rates rose by 1.0%, up to 5.0%, the new monthly payment would consume 20.1% of gross income. Needless to say, as rates rise, the housing recovery will soften.

What’s the Problem, Then?

Here's my concern. Based on how the financial markets reacted to the mere suggestion of a reduction in the Fed's bond buying program, what will be its reaction when the Fed finally begins to taper?

I believe it's possible that we could see an overreaction severe enough to cause investor fear to spike which could derail our already anemic recovery. After all, the crux of the issue today is weak demand. Anything that could further weaken demand would be a negative for the economy.

Hence, I believe this is an issue worth watching; if it actually does materialize, well, I'll let you draw your own conclusion. I'll just say there is plenty of uncertainty out there, and yes, we could see a bull run, but at some point, I think the potential exists for a rather dire period. I do hope I'm wrong, but I will remain cautious in the interim. Oh, did I mention we're going to swear in a successor when Bernanke leaves his post? Need I say more?

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